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Need for Depreciation:

The need for providing depreciation in accounting records arises from conceptual, legal, and practical business consideration. These considerations provide depreciation a particular significance as a business expense.

Matching of Costs and Revenue : The rationale of the acquisition of fixed assets in business operations is that these are used in the earning of revenue. Every asset is bound to undergo some wear and tear, and hence lose value, once it is put to use in business. Therefore, depreciation is as much the cost as any other expense incurred in the normal course of business like salary, carriage, postage and stationary, etc. It is a charge against the revenue of the corresponding period and must be deducted before arriving at net profit according to ‘Generally Accepted Accounting Principles’.

Consideration of Tax: Depreciation is a deductible cost for tax purposes. However, tax rules for the calculation of depreciation amount need not necessarily be similar to current business practices,

True and Fair Financial Position: If depreciation on assets is not provided for, then the assets will be over valued and the balance sheet will not depict the correct financial position of the business. Also, this is not permitted either by established accounting practices or by specific provisions of law.

Compliance with Law : Apart from tax regulations, there are certain specific legislations that indirectly compel some business organisations like corporate enterprises to provide depreciation on fixed assets.

Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.

According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.”

Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is pre-determined”.

Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:

“are expected to be used during more than one accounting period;

have a limited useful life; and

are held by an enterprise for use in production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.”

Depreciation and other Similar Terms:

There are some terms like ‘depletion’ and ‘amortisation’, which are also used in connection with depreciation. This has been due to the similar treatment given to them in accounting on the basis of similarity of their outcome, as they represent the expiry of the usefulness of different assets.

Karnataka class 12 commerce Accountancy Need for charging depreciation-Depletion: The term depletion is used in the context of extraction of natural resources like mines, quarries, etc. that reduces the availability of the quantity of the material or asset. For example, if a business enterprise is into mining business and purchases a coal mine for Rs. 10,00,000. Then the value of coal mine declines with the extraction of coal out of the mine. This decline in the value of mine is termed as depletion. The main difference between depletion and depreciation is that the former is concerned with the exhaution of economic resources, but the latter relates to the usage of an asset. In spite of this, the result is erosion in the volume of natural resources and expiry of the service potential. Therefore, depletion and depreciation are given similar accounting treatment.

Karnataka class 12 commerce Accountancy Need for charging depreciation-Amortisation: Amortisation refers to writing-off the cost of intangible assets like patents, copyright, trade marks, franchises, goodwill which have utility for a specified period of time. The procedure for amortisation or periodic write-off of a portion of the cost of intangible assets is the same as that for the depreciation of fixed assets. For example, if a business firm buys a patent for Rs. 10,00,000 and estimates that its useful life will be 10 years then the business firm must writeoff Rs. 10,00,000 over 10 years. The amount so written- off is technically referred to as amortisation.

Factors Affecting the Amount of Depreciation: The determination of depreciation depends on three parameters, viz. cost, estimated useful life and probable salvage value.

Cost of Asset Cost (also known as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to put the asset in use or working condition. Besides the purchase price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc. In case of purchase of a second hand asset it includes initial repair cost to put the asset in workable condition. According to Accounting Standand-6 of ICAI, cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”. For example, a photocopy machine is purchased for Rs. 50,000 and Rs. 5,000 is spent on its transportation and installation. In this case the original cost of the machine is Rs. 55,000 (i.e. Rs. 50,000 + Rs.5,000 ) which will be writtenoff as depreciation over the useful life of the machine.

Estimated Net Residual Value Net Residual value (also known as scrap value or salvage value for accounting purpose) is the estimated net realisable value (or sale value) of the asset at the end of its useful life. The net residual value is calculated after deducting the expenses necessary for the disposal of the asset. For example, a machine is purchased for Rs. 50,000 and is expected to have a useful life of 10 years. At the end of 10th year it is expected to have a sale value of Rs. 6,000 but expenses related to its disposal are estimated at Rs. 1,000. Then its net residual value shall be Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).

Depreciable Cost Depreciable cost of an asset is equal to its cost (as calculated in point 7.5.1 above) less net residual value (as calculated in point 7.5.2,) Hence, in the above example, the depreciable cost of machine is Rs. 45,000 (i.e., Rs. 50,000 – Rs. 5,000.) It is the depreciable cost, which is distributed and charged as depreciation expense over the estimated useful life of the asset. In the above example, Rs. 45,000 shall be charged as depreciation over a period of 10 years. It is important to mention here that total amount of depreciation charged over the useful life of the asset must be equal to the depreciable cost. If total amount of depreciation charged is less than the depreciable cost then the capital expenditure is under recovered. It violates the principle of proper matching of revenue and expense.

Estimated Useful Life Useful life of an asset is the estimated economic or commercial life of the asset. Physical life is not important for this purpose because an asset may still exist physically but may not be capable of commercially viable production. For example, a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can’t be used for production profitably, i.e., if it is still used the cost of production may be very high. Therefore, the useful life of the machine is considered as 5 years irrespective of its physical life. Estimation of useful life of an asset is difficult as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes, market changes, etc. As per Accounting Standard – 6 useful life of an asset is normally the “period over which it is expected to be used by the enterprise”. Normally, useful life is shorter than the physical life. The useful life of an asset is expressed in number of years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. Useful life depends upon the following factors :

Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease.